# Least Cost Decisions:

Revenues are not directly involved in some decisions. For example, a company that does not charge for delivery service may need to replace an old delivery truck, or a company may be trying to decide whether to lease or to buy its fleet of executive cars.

In situations such as these, where no revenues are involved, the most desirable alternative will be the one that promises the least total cost from the present value perspective. Hence, these are known as least cost decisions. To illustrate a least cost decision, consider the following data:

## Example:

Val-Tek Company is considering the replacement of an old threading machine. A new threading machine is available that could substantially reduce annual operating costs. Selected data relating to the old and the new machines are presented below:

 Old Machine New Machine Purchase cost when new \$200,000 \$250,000 Salvage value now 30,000 — Annual cash operating costs 150,000 90,000 Overhaul needed immediately 40,000 — Salvage value in six years 0 50,000 Remaining life 6 years 6 years Val-Tek Company uses a 10% discount rate

### Total Cost Approach or Total Cost Method:

Following is the analysis of the alternatives using total cost approach:

The Total Cost Approach (Lease Cost Decision)

 Item Year(s) Amount of Cash Flows 10% Factor* Present Value of Cash Flows Buy the new machine: Initial investment Now \$(250,000) 1.000 \$(250,000)** Salvage of the old machine Now 30,000 1.000 30,000** Annual cash operating cost 1 – 6 (90,000) 4.355 (391,950) Salvage of the new machine Now 50,000 0.564 28,200 Net present value 583,750 Keep the old machine: Overhaul needed now Now \$(40,000) 1.000 (40,000) Annual cash operating costs 1 – 6 (150,000) 4.355 (653,250) present value of net cash outflows \$693,250 Net present value in favor of buying the new machine \$109,500 * All present value factors are from Future Value and Present Value Tables page – Table 3 and Table 4. ** These two figures could be netted into a single \$220,000 incremental cost figure (\$250,000 – \$30,000 = \$220,000)

As shown in the above solution, the new machine has the lowest total cost when the present value of the net cash outflow is considered.

### Incremental Cost Approach or Incremental Cost Method:

An analysis of the two alternatives using the incremental cost approach is presented below:

The Incremental Cost Approach (Lease Cost Decision)

 Item Year(s) Amount of Cash Flows 10% Factor* Present Value of Cash Flows Incremental investment to buy the new machine Now \$(210,000) 1.000 \$(210,000)** Salvage of the old machine Now 30,000 1.000 (30,000)** Salvage in annual cash operating costs 1 – 6 60,000 4.355 261,300 Difference in salvage value in six years 6 50,000 0.564 28,200 Net present value in favor of buying the new machine \$109,500 * All present value factors are from Future Value and Present Value Tables page – Table 3 and Table 4. ** These two items could be netted into a single \$180,000 incremental cost figure (\$210,000 – \$30,000 = \$180,000).

This solution represents the differences between the alternatives as shown under the total cost approach.

In Business | Trading in that Old Car?Consumer reports magazine provides the following data concerning the alternatives of keeping a four year old Ford Taurus for three years or buying a similar new car to replace it. The illustration assumes the car would be purchased and used in suburban Chicago.

 Keep the Old Taurus Buy a New Taurus Annual maintenance \$1,180 \$650 Annual insurance 370 830 Annual license 15 100 Trade-in value in three years 605 7,763 Purchase price, including sales tax 17,150

Consumer Reports is ordinarily extremely careful in its analysis, but it has omitted in this case one financial item that would clearly differ substantially between the alternatives and hence would be relevant. What is it?

Source: “When to Give Up on Your Clunker,” Consumer Reports, August 2000, pp. 12-16.